Monthly Archives: July 2011

In the last two weeks we asked, and answered, the question: why would anyone accept a “fiat currency” that has no intrinsic value without precious metal backing? We have argued that legal tender laws, alone, are not sufficient because it is generally too difficult for government to enforce them. Further, we know that “fiat currencies” are often accepted even where their use is not required (ie: where there are no legal tender laws, or at least none that are applicable).

We concluded that “taxes drive money”: if a sovereign has the power to impose and enforce a tax liability, it can ensure a demand for its currency. This is the one transaction that government can ensure its “fiat currency” is used: in payments made to itself.

We also concluded that other kinds of obligations will work: if you need the currency to pay fees, fines, or tithes, you will demand at least enough currency to make those payments. And, finally, we argued that an authority that monopolizes a needed resource (land, energy) can “name the price”, i.e., dictate what must be delivered to obtain it. So that, too, could drive a currency—and, again, it is because the authority can choose the form in which the payment is made.

The best kind of payment is an obligatory one—one that must be made to stay out of prison, or to avoid death by thirst. An obligatory payment that must be made in the sovereign’s own currency will guarantee a demand for that currency.

And we argued that even if one does not owe taxes (or fees, etc.) to the sovereign, one might still accept the currency knowing that others do have tax liabilities and thus will accept the currency. But how much currency will be accepted? Can the sovereign issue more than the tax liability? How much more?

Imposing and enforcing a tax liability ensures that at least those subject to taxes will want the domestic currency, in an amount at least equal to the tax liability that will be enforced. In the developed nations, the population is willing to accept more domestic currency than what is needed for tax payments—typically government does not find sellers unwilling to sell for its currency.

The normal case—let us say, in the US or the UK or Japan—is that anything for sale is for sale in the domestic currency. These sovereign governments never find that they cannot buy something by issuing their own currency.

To be clear: if there is something for sale with a US Dollar price, it can be bought by delivering US currency. (We will just note a caveat here, to be explained more fully later: sometimes, especially for payments made by mail, paper currency and coins are not accepted. But when a payment is made by check, there is a transfer of bank reserves—a kissing cousin to sovereign currency.)

However, the situation can be different in developing nations in which foreign currencies might be preferred for “private” transactions (payments that do not involve the sovereign). To be sure, the population will want sufficient domestic currency to meet its tax liability, but the tax liability can be limited by tax avoidance and evasion. This will limit the government’s ability to purchase output by making payments in its own currency.

We can get a rough idea of the limit imposed on a government whose population prefers foreign currency. Let us say that the government imposes a tax liability equal to one-third of measured GDP. However, because the informal sector escapes accounting, let us assume that GDP only represents half of the true level of output.

Further assume that government is only able to collect half of imposed taxes due to evasion. This means that collected taxes equal only one-sixth of measured GDP and only one-twelfth of true output and income. (Hello, Greece! Just kidding, but that is one of the claims frequently made.)

At a minimum, in such a situation government will be able to move one-twelfth of national output to the public sector through its spending of the domestic currency (since those who really do have to pay taxes need the domestic currency to meet their obligations).

In practice, the government will probably be able to capture more than one-twelfth of national output because some “private” entities (domestic and perhaps foreign) will want to accumulate domestic currency as well as other claims on government (such as government bonds)—recall from previous discussion that government deficits allow accumulation of net financial wealth in the form of government IOUs. Hence it is likely that government will be able to purchase somewhat more than a twelfth of GDP, while collecting taxes equal to a twelfth of national income, with some households or firms (or foreigners) accumulating the rest of the currency spent as net financial wealth.

(These calculations are necessarily approximate because we are ignoring possible effects of taxing and spending on the behaviour of the population. For example, imposing a tax can drive more production into the “grey market”, leaving measured GDP and taxable income lower.)

To capture a larger per cent of national output, government needs to pursue policies that will a) reduce tax evasion and b) formalize more of the informal sector. Both of those actions would increase taxes on the population and would allow government to obtain more output.

If taxes are at just one-twelfth of national output, it might not be effective for government to simply increase its spending to try to move more resources to the public sector—this could just result in inflation, as sellers would accept more domestic currency only at higher prices (as they already have all the currency they need to meet the tax obligation they think will be enforced). And beyond some point, government might not find any sellers for additional currency.

While it would be incorrect—for reasons explored later—to argue that taxes “pay for” government spending, it is true that inability to impose and enforce tax liabilities will limit the amount of resources government can command.

The problem is not really one of government “affordability” but rather of limited government ability to mobilize resources because it cannot impose and enforce taxes at a sufficient level to achieve the desired result.

Government can always “afford” to spend more (in the sense that it can issue more currency), but if it cannot enforce and collect taxes it will not find sufficient willingness to accept its domestic currency in sales to government.

Put simply, the population will find it does not need additional domestic currency if it has already met the tax liability the government is able to enforce (plus some accumulation of currency for contingency purposes). In that case, raising taxes would increase demand for government’s currency (to pay the taxes), which would create more sellers to government for its currency.

Until government can impose and collect more taxes, its spending will be constrained by the population’s willingness to sell for domestic currency. And that, in turn, is caused by a preference for use of foreign currency for domestic purposes other than paying taxes. While this is not a big problem in developed countries, it can be a serious problem in developing nations.

In this blog, we have presumed government spends and taxes using currency (notes and coins). In practice, governments use checks and increasingly use electronic entries on bank accounts. Indeed, government uses private banks to accomplish many or most transactions related to spending and taxing.

In coming weeks we will provide a more “realistic” account of taxing and spending using bank accounts rather than actual currency. This does not change anything of substance—but it does require some understanding of banking, central banking, and treasury operations, discussed in the following blogs.

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You have to wonder if the president ever hears from his commerce secretary these days. Friday’s GDP revisions by the Bureau of Economic Analysis should send a pretty strong signal that the economy is far from recovering, making clear that job killing spending cuts should be last thing on his mind:

“While the headline number was well below expectations of 1.8%, what must be noted are the major revisions. Q1 2011 is now reported as +0.4%. That’s a major downward revision which demonstrates that QE2 was in fact doing nothing for growth and that the US is already at stall speed even without the negative impact of the European sovereign debt crisis and the debt ceiling fiasco. The double dip scare is real.” Ed Harrison, Credit Writedowns

Unfortunately, the president doesn’t demonstrate any evidence that he’s heard this news. For all we know, he might have tasked Secretary Locke to go out and “truck, barter and trade” with the American people in an effort to win the future. So maybe instead of leveling with the president, Locke is out setting up lemon-aid stands across the country. Who knows?

Judging by the evidence available to me, I have to assume that Obama is either willfully ignorant of the dire situation or patently insane enough to believe that we are in the midst of a recovery. Or perhaps he is fully aware that we are on the verge of a fresh contraction, but thinks the best way to increase business activity is to drive up unemployment.

No, I’m sure Gary Locke is hard at work doing the sort of thing you would expect a cabinet level official to do, not off trying to inspire confidence in the business community through conspicuous acts of commerce. The president has heard the news alright. The problem lies in his commitment to, above all else, selling us a phony crisis:

“Now, every family knows that a little credit card debt is manageable. But if we stay on the current path, our growing debt could cost us jobs and do serious damage to the economy. More of our tax dollars will go toward paying off the interest on our loans. Businesses will be less likely to open up shop and hire workers in a country that can’t balance its books. Interest rates could climb for everyone who borrows money – the homeowner with a mortgage, the student with a college loan, the corner store that wants to expand. And we won’t have enough money to make job-creating investments in things like education and infrastructure, or pay for vital programs like Medicare and Medicaid.” President Obama, July 25, 2011

Here he appeals to our fear of the unknown, leading us to conclude that if we don’t reduce the deficit now we will pay dearly tomorrow. This passage is especially troubling given its blatant disregard for the truth. The federal government is not a household – he has yet again committed the classic fallacy of composition. The public debt is not analogous to Joe the Plumber’s Visa card. Not even close. In fact, they are pretty much opposite each other: public debt is private savings, while credit cards are tools for private sector deficit spending. From there, he tries to convince us that as deficits increase more of the spending pie will go towards debt service. Sure, if the economy does not grow with the deficit that might be the case.

So what? Well, the connection he is hoping we’ll make is that this will eventually leading to exploding deficits and increasing interest rates. He seems to forget that we have a sovereign currency, and we spend by crediting bank accounts regardless of the sentiment of the bond market. We decide how much to pay in interest, not bond vigilantes. And he finishes the argument by asserting that we will not “have enough” money to pay for Medicare and Medicaid, which is patently false. To pay for those programs you simply credit the bank accounts of recipients. The money does not exist before that transaction, so it is nonsense to suggest you can ever lack the funds to make the payments. Of course, you can fail to make the keystrokes necessary to initiate the transaction, but that is not insolvency only political failure.

Up until now, I’ve been inclined to give Obama the benefit of the doubt. I figured that while he does not seem to understand how the modern economy functions, at least he is in earnest over his deficit fears. After all, he has surrounded himself with advisers that lack the insight to make effective policy recommendations so why should he know any better? But, as Dean Baker points out he is apparently unaware of the actual size of the deficit, a matter which he has chosen to make the central pillar of his four years in the Oval Office. In a gaffe, the president claimed that he inherited a deficit that was approaching $1 trillion for his inaugural year, while the CBO’s projections placed it at the much lower figure of $198 billion.

That’s a little too wide of the goalposts for my comfort, and it leads me to speculate whether or not he really believes his own rhetoric. After all, if you desperately want to convince Americans that hacking away at the social safety net is a good idea, you would think you’d have your facts straight. If he really believes the deficit is too large, then you wouldn’t you think he would know just how large it is?

Unless, of course, you let slip those kind of statements on purpose. Inheriting a trillion dollar budget deficit from your predecessor sounds a lot more urgent than a couple billion. And if you want to convince your constituency to roll over and accept cuts in the very programs that have been core to the Democratic party for the better part of a century, you had better be sure to make them believe those cuts to be absolutely necessary.

The new BEA figures about economic activity continue to point to a replay of a Japanese-style lost decade or, even worse, a 1937 scenario. The current expansion has been the weakest on record since World War Two and the trend since the early 1980s does not provide much comfort. Figure 1 shows that each economic expansion since the 1980s has been weaker and weaker and the rate of decline has accelerated.

The current debate in Washington does not provide any comfort for the short run or the long run with both political parties willing to jeopardize whatever economic growth we have left over a fictitious ceiling that serves no economic purpose. All this suffering is supposed to help in the long run because of the good that will come from “reforming” (read “dismantling”) pillars of economic progress like Social Security.

The 2009 Obama “stimulus” is long gone and all levels of government negatively contributing to economic growth. Since the third quarter of 2009, the contribution of the government to economic growth has been nil on average.

Keynes once said that “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist” (Keynes 1964, 383). Two among those modern economists must surely be Reinhart and Rogoff, as no other book in recent history has contributed so much to the mass phobia and delusion about the debt and the deficit as theirs. This is a book that reinforces some of the worst ideas in the economics profession, a profession that refuses to acknowledge that we are no longer on a gold standard and that a government which has a monopoly over its own currency can both supply it without facing default and regulate its value.

Last May, John T. Harvey wrote a wonderful post about the quantity theory of money (QTM). This post picks up where John stopped, presenting a different theory of the price level and inflation. It’s a bit technical (so bare with me), but many readers have asked us to elaborate on price theory.

First, a quick recap. The QTM starts with the identity MV ≡ PQ, where M = the money supply, V = the velocity of money, P = the price level, and Q = the quantity of output (Fisher’s version is broader and includes all transactions: T). The identity is a tautology, it just says that the amount of transactions on goods and services (PQ) is equal the to the amount of financial transactions needed to complete those transactions. To get a theory of price (the QTM), one must make some assumptions about each variable. The QTM assumes that:

·M is constant (or grows at a constant rate) and is controlled by the central bank through a money multiplier

·V is constant

·Q is constant at its full employment level (Qfe) or grows at its natural rate (gn)

Given this set of assumptions, we get (note the equality sign to signal causality):

P = MV/Qfe

Or, in terms of the growth rate (V is constant so its growth rate is zero):

gp = gm – gn

This is the QTM, which holds that price changes (inflation and deflation) have monetary origins, i.e. if the money supply grows faster than the natural rate of economic growth, there is some inflation. For example, if gm = 2% and gn = 1% then gp = 1%. If the central bank increases the money supply, then inflation rises.

John’s post explains the problems with this theory. M is endogenous, V is not constant, and the economy is rarely at full employment. If you want to know more, you should read John’s post.

Let’s move to an alternative theory of the price level and inflation by starting with another identity based on macroeconomic accounting:

PQ ≡ W + U

This is the income approach to GDP used by the Bureau of Economic Analysis. It says that nominal GDP (PQ) is the sum of all incomes. For simplicity, there are only two incomes: wage bill (W) and gross profit (U). Both are measured before tax.

Let’s divide by Q on each side:

P ≡ W/Q + U/Q

We can go a bit further by noting that W is equal to the product of the average nominal wage rate and the number of hours of labor W = wL (for example, if the wage rate is $5 per hour, and L is equal to 10 hours, then W is equal to $50). Thus:

P ≡ wL/Q + U/Q

Q/L is the quantity of output per labor hour, also called the average productivity of labor (APl) therefore:

P ≡ w/APl + U/Q

w/APl is called the unit cost of labor and data can be found at the BLS. The term U/Q will be interpreted a bit later.

Ok let’s stop a bit here. For the moment all we have done is rearranged terms, we have not proposed a theory (i.e. a causal explanation that provides behavioral assumptions about the variables.) Here they are:

·The economy is not at full employment and Q (and economic growth) changes in function of expected aggregate demand (this is Keynes’s theory of effective demand).

·w is set in a bargaining process that depends on the relative power of workers (the conflict claim theory of distribution underlies this hypothesis)

·APl moves in function of the needs of the economy and the state of the economy.

Thus we have:

P = w/APl + U/Q

Thus the price level changes with changes in the unit cost of labor and the term U/Q. What is this last term? To understand it let’s express the previous equation in terms of growth rate. This is approximately:

gp = (gw – gAPl)sW + (gU – gQ)sU

With sW and sU the shares of wages and profit in national income (sW + sU = 1).

Thus, inflation will move in relation to the growth rate of the unit labor cost of labor, which itself depends on how fast nominal wages grow on average relative to the growth rate of the average productivity of labor. As shown in the following figure, in the United States, a major source of inflation in the late 1960s and 1970s was the rapid growth of the unit cost of labor, with the rate of change between 5 and 10 percent.

Inflation will also move in relation to the difference between the growth rate of U and the growth rate of the economy (gQ). U follows Kalecki’s equation of profit, which broadly states that that the level of profit in the economy is a function of aggregate demand. Thus the term, (gU – gQ) represents the pressures of aggregate demand on the economy. If gU goes up and gQ is unchanged, then gP rises given everything else. However, to assume that gQ is constant is not acceptable unless the economy is at full employment, so a positive shock on aggregate demand will usually lead to a positive increase in gQ.

Thus, overall, there are two sources of inflation in this approach, a cost-push source (here summarized by the unit labor cost) and a demand-pull source (here summarized by the aggregate demand gap). Note that the money supply is absent from this equation. Money does not directly affect prices. Assuming that a drop of money from the sky leads to inflation, first, does not understand how the money supply is created (it is at least partly created to produce goods and services), second, assumes that people will automatically spend rather than hoard the addition funds obtained (people do hoard for all sorts of reasons and do derive “utility” from hoarding money), third, assumes that the economic output cannot respond to additional demand. If more people suddenly go to the store, producers usually produce more rather than raise prices. Output is not a fixed pie that involves allocation to one group at the expense of another group. The size of the pie increases and decreases with the number of people demanding pie.

A version of this theory has been used in many different models that have endogenous money, liquidity preference, demand-led theory of output and other non-mainstream characteristics. Godley’s and Lavoie’s Monetary Economics as well as Lavoie’s Foundation of Post Keynesian Economics are good books to get more modeling. Of course, modern mainstream monetary economics is rejected in those books; income effect dominates over substitution effect, production is emphasized over allocation, monetary profit affects economic decisions, etc. Be prepared for a change of perspective in which scarcity is not the starting point of economics.

Thanks again for well-focused questions and comments. Here we are concerned with why government “fiat”currency is accepted. The short answer was that “taxes drive money”: since you have a tax liability that must be cleared by delivering the government’s own currency back to government, you want to obtain government currency. So in that sense, it is the tax liability that drives the desire to obtain government currency.

I did leave a couple of teasers, which some touched on in their comments. First, does it have to be a tax? Clearly the answer is “no”: if government imposes a fine on you in the form of five Dollars, you need five Dollars in the form government is willing to accept to pay your fine—sovereign currency. Until the 20th century, taxes were relatively less important; what mattered more were fines and tithes and fees.

To go further, let us say government monopolizes the water supply (or energy supply, or access to the gods, etc); it can then name what you need to deliver to obtain water (energy, religious dispensation, etc). In that case, if it says you must obtain a government IOU, then you want government IOUs—currency—to obtain water in order to avoid death by dehydration. In early 19th century England, almost all activities necessary to keep your family alive were illegal by dictate of the crown. You had to pay a fine after you killed game to feed your family. You needed the crown’s currency to pay the fine—hence “fees drove money”. You get the picture.

All you need to drive a currency is a more or less involuntary obligation to deliver the currency—and that can be a tax, fee, fine, or even religious tithe. Or a payment to obtain water or any other necessity. We can go into this later, but at UMKC students need buckaroos to pay a “tax” to pass their courses—that drives the buckaroo currency—it creates a demand for buckaroos (the sovereign currency at UMKC).

That answers the question: yes it is not enough to impose the obligation (fee, fine, tax); the obligation must also be enforced. A tax liability that is never enforced will not drive a currency. A tax that is only loosely enforced can create some demand for the currency, but it will be somewhat less than the tax liability for the simple reason that many will expect they can evade the tax.

We can next move on to the second teaser: why would those who do not have tax liabilities also be willing to accept currency?

That leads us to the Tobin, “snowball” point: if some segment of society owes the tax (or fee or fine) denominated in the currency, others will accept it. Note this is not an infinite regress argument. It is the tax standing behind the currency. But it is not necessary for every individual to owe the tax.

Let us say that Bill Gates owes $1.5 trillion in taxes. I’d be happy to accept Dollars since I know Gates will accept them when I purchase Microsoft software. And that explains why foreigners want dollars—not because they owe taxes, but because a sufficient number of Bill Gates do.

From inception we know that if the total tax liability in dollars is, say, $100 billion, the taxpayers will want a minimum of $100 billion. (How much more? $120 billion? $180 billion? We will investigate that later.) Government can spend into the economy at least that amount.

How much will the Dollar be worth? Well, that depends on what must be done to obtain it. We will have much more to say about that in coming weeks.

A commentator did hit on this point: what if the tax liability is too low? Let us say the tax liability is $100 billion but government tries to spend $1000 billion. This is ten times what the taxpayers need to cover their liabilities. It is possible—even probable—that government will not be able to find takers for the $1000 billion. It can bid the price it is willing to pay (for labor, finished output, or resource inputs) up, but still find no takers. We could register “inflation” and still find government cannot spend as much as it wants.

A better solution—obviously—is to raise the tax liability toward $1000 billion, rather than to increase the price government is willing to pay. Again, that is something we will come back to, but it also sheds some light on what determines the value of the currency. As I said last week, we need to separate the willingness to accept currency from the value of the currency. Raising the tax liability will increase the desire to obtain currency although that does not tell us exactly how much the value of currency (in terms of labor or other resources) will rise.

Valuing something like a bridge is very difficult—especially if we are talking about a bridge already in place. Fortunately, it is also a question that is not very important, so long as the bridge is public—not owned by some profit seeking entity. There really is very little reason to value public infrastructure once it is in place, except perhaps in terms of all the pleasure it provides to the population. That is probably something that cannot be and should not be measured in money terms.

But, yes, raising the tax liability while holding government issue of the currency constant is likely to lead to what we might call unemployment: those willing to work to get the currency in order to pay taxes, but who cannot find work or demand for output to obtain the currency.

We will later go through the accounting to answer the question raised by a commentator: what about the reserve effects of tax payments? But, briefly, yes, paying taxes will all else equal reduce outstanding bank reserves. In practice, if the central bank targets overnight interest rates, it will replace lost reserves if they were desired or required—by lending at the discount window or through open market purchases of treasuries.

There were several questions/comments that were not comprehensible to me: what about interest, which requires one to repay more than what is owed. I do not see the relevance to this week’s topic. What about issuing money with no offsetting debt? Well, all money “things” are IOUs hence are debts, hence there is no possibility of issuing money that is not a debt. What about socio/political ramifications of who pays the tax? Yes very important, but I do not see the relevance to the topic at hand.

OK I hope I have covered the main comments and questions. More next week.

By reviewing the annual reports (2005-2007) of President Bush’s Council of Economic Advisors (CEA) I learned that the Council had some interest in fraud, but no understanding of elite fraud and its implications for the economy.The reports make sad reading.They deny the developing crisis entirely and they do so for reasons that reflect badly on economics and economists.

The CEA’s reports’ analysis of the developing fraud epidemics and crisis reveal critical weaknesses in theory, methodology, empiricism, candor, objectivity, and multi-disciplinarity.Overwhelmingly, the reports ignored the developing crises and their causes.Worse, as late as 2007, they denied – even after the bubble had popped – that there was a housing bubble.When the nation and the President vitally needed a warning from its Council of Economic Advisors the CEA did not simply fail to warn, but actually advised that those who warned of a coming crisis were wrong.

This column does not focus on the CEA’s claims that there was no housing bubble.Like the National Association of Realtors’ top economist who became known to the trade press as “Baghdad Bob” (the mocking nickname journalists gave Saddam Hussein’s press flack after he denied U.S. troops were in Baghdad), the CEA’s specious bubble denial is an obvious embarrassment.Their Japanese counterparts did far better in warning of the developing real estate bubble in the 1980s.The collapse of the twin Japanese bubbles in 1990 and the resultant “lost decade” should have caused the CEA to recognize the gravity of the risk bubbles pose and importance of identifying them promptly.Instead, the CEA gave in to the temptation to claim that the President’s brilliant policies had produced a wonderful economy.The reality was that the economy was headed over the precipice.

The focus of this column is on the portion of the CEA’s annual report for 2006 that discussed the theory of financial intermediation and financial regulation.Indeed, the column focuses on a small subset of the defects in those portions of the report.I write to emphasize how a theory (“control fraud”) developed two decades ago by regulators, criminologists, and economists could have saved the CEA from analytical and policy errors with regard to financial crises and regulation and led it to identify the crisis and recommend effective measures to contain it.The tragedy is that the CEA discussion of the theory of financial regulation embraces three of the most useful theoretical insights – adverse selection, lemon’s markets, and the centrality and criticality of sound underwriting to the survival of lending institutions.These theories are interrelated and they are essential components of control fraud theory.

Had the CEA understood the true import of these three economic theories it could have gotten the crisis right instead of making things worse.White-collar criminologists and economists share these three theories (among others) and employ a (limited) “rational actor” model.(Criminologists never made the mistake of assuming purely rational behavior.Even neoclassical economists now generally acknowledge that behavioral economics research demonstrates that economic behavior can be irrational in important settings.)In the 1980s and early 1990s, the efforts of a small group of criminologists, economists, and regulators to understand the causes of the developing S&L debacle led them to develop a synthetic theory that criminologists refer to as “control fraud theory.” Unfortunately, the typical theoclassical economic treatment of these three theories, exemplified by the CEA’s 2006 report, ignores control fraud.The result is that the 2006 CEA report misstated the predictions of each of the three theories that it discussed and concluded “no problem here.”In reality, the three theories predicted that there were epidemics of accounting control fraud

that were leading inevitably to a catastrophic crisis.

The context of the 2006 CEA report’s discussion of the three theories is a treatise on the theory of financial intermediation and its implications for financial regulation.The treatise is over the top in its praise of the U.S. financial industry.The CEA claimed that the U.S. financial deregulation gave its financial sector a “comparative advantage” over other nations.The CEA cited the financial sector’s rapid growth in size and profits as proof of this comparative advantage and asserted that the financial sector’s rapid growth led to more rapid U.S. economic growth and increased financial stability.The CEA’s theory of financial intermediation posited that banks exist to minimize the informational difficulties that beset lending and investment.The CEA concluded that U.S. banks were growing rapidly because deregulation made them ever more efficient in minimizing these informational defects.

Adverse Selection

The CEA addressed three forms of informational defects that banks helped reduce.The CEA began by discussing “adverse selection.”Adverse selection was the key to understanding and preventing the developing crisis.In the lending context, adverse selection arises when a lender’s policies selectively encourage lending to borrowers who pose greater credit risks that are unknown or underestimated by the lender.Adverse selection can be one of the consequences of “asymmetrical information.”(Adverse selection also poses a serious risk to honest insurance companies.)

Because the lender does not know (and therefore is not compensated for) the full extent of the risk of default adverse selection produces a “negative expected value” for lenders.In plain English, they lose money.For a residential mortgage lender, adverse selection is fatal because the loans are so large and the loan proceeds are fully disbursed at closing.It is essential to understand that adverse selection is not equivalent to credit risk.A mortgage lender makes money by taking prudent credit risks.Banks “underwrite” prospective borrowers and collateral in order to identify, understand, quantify, and price credit risk.Prudent underwriting minimizes adverse selection.Mortgage lenders that fail to underwrite create severe adverse selection and fail.Honest home lenders would never gut their underwriting standards and create adverse selection.

The existence of a secondary market does not change an honest home lender’s incentive to engage in prudent underwriting.Neoclassical theory predicts that the ultra sophisticated investment banks that ran the secondary market would only purchase loans they had prudently underwritten.A lender that failed to underwrite effectively would be unable to sell its loans in the secondary market.Neoclassical theory also predicts that the secondary market would only purchase loans sold with guarantees against fraud.The first prediction, of course, proved false but the second prediction was typically true.All of the mortgage lenders that specialized in making large numbers of loans under conditions that maximized adverse selection failed even before the cost of the guarantees would have destroyed them because their “pipeline” losses exceeded their trivial (fictional) capital.

The most severe form of adverse selection is fraud.The ultimate form of adverse selection is accounting control fraud.Any experienced banker or insurer knows that adverse selection can lead to fraud.Fraud maximizes the asymmetry of information because the information provided to the victim contains data that are false and material.The fraud makes the loan look far less risky than it really is.

In 2006, MARI, the anti-fraud group of the Mortgage Bankers Association (MBA), reported to MBA members that “stated income” loans were an “open invitation to fraudsters” and that they deserved the term used behind closed doors in the industry, “liar’s loans,” because the incidence of fraud in liar’s loans was 90 percent.The defining element of liar’s loans was the failure to conduct essential underwriting.Moreover, fraudulent nonprime lenders typically simultaneously maximized adverse selection and created deniability by creating large networks of loan brokers to prepare the fraudulent loan applications.

The percentage of nonprime loans made without prudent underwriting is not known with precision because there were no official definitions of stated income, alt-a, or liar’s loans.Subprime and liar’s loans were not mutually exclusive.By the time the CEA wrote its 2006 report roughly half of the loans lenders termed “subprime” were also liar’s loans.Credit Suisse’s March 12, 2007 study (“Mortgage Liquidity du Jour: Underestimated No More”) presented data estimates that roughly 30% of all mortgage loans made in 2006 were liar’s loans.That frequency produces an annual mortgage fraud incidence of well over one million.The FBI had put the entire nation on alert about the developing “epidemic” of mortgage fraud in its September 2004 House testimony.The FBI predicted that the fraud epidemic would cause a financial “crisis” unless the epidemic was contained.In 2006, no one believed that the epidemic was being contained.

What everyone, including the CEA, knew in 2006 was that mortgage underwriting standards for nonprime loans were in freefall while other “layered risk” characteristics were multiplying.This meant that nonprime lenders were dramatically increasing adverse selection while making loans that were ever more vulnerable to losses from adverse selection.Everyone, including the CEA, knew that the only reason this could occur was the rapid growth of the three “de’s” – deregulation, desupervision, and de facto decriminalization.Everyone, including the CEA, knew that no one was forcing the nonprime lenders to make liar’s loans.That should have led the CEA to ask why the senior officers controlling nonprime lenders were deliberately causing the lenders to make loans that created intense adverse selection, endemic fraud, massive (longer-term) losses, and the failure of the lender.That behavior makes no sense under the theory of financial intermediation advanced by the CEA.No honest lender CEO would engage in that pattern of behavior.The nonprime lender CEOs’ behavior only makes sense if they are engaged in accounting control fraud.The recipe for maximizing fictional accounting income has four ingredients and adverse selection optimizes the first two (rapid growth through making very poor quality loans at premium yields).

Unfortunately, the CEA’s 2006 report was devoid of any real analytics or facts related to adverse selection.Indeed, the report’s entire discussion of financial institutions is bizarre because it is not simply removed from any factual context but based on factual assumptions that were contrary to reality and becoming ever more contrary to reality in 2006.The discussion is a surreal theoretical exercise based on unstated factual assumptions that are the opposite of reality.The (inevitable) result of its unstated assumptions is the worst possible financial regulatory policy advice that the CEA could give in 2006 – everything is wonderful because our financial intermediaries prevent adverse selection.The CEA wrote to warn us of the dangers of excessive financial regulation at a time when financial regulation had been eviscerated.

The CEA’s discussion of adverse selection ignored the risk of fraud during what the FBI had aptly termed a fraud “epidemic.”Instead, it premised its concern on managers of high quality projects being unwilling to seek commercial loans from banks because banks charged excessive interest rates for even high quality projects because of their inability to differentiate bad and high quality business projects.In reality, interest rates on commercial loans were exceptionally low – even for poor quality business projects.The CEA’s discussion of adverse selection was premised on an alternate universe.

Lemon Markets

The CEA discussed lemon markets in conjunction with its discussion of adverse selection.A lemon market reaches its nadir when bad quality products drive good quality products out of the marketplace.Control fraud theory agrees that lemon market and adverse selection are interrelated theories and provide the keys to understanding why control frauds cause such devastating injury.George Akerlof was awarded the Nobel Prize in Economics in 2001 for his 1970 article on markets for lemons, which was a pioneering article on fraud and asymmetrical information.As I have explained, fraud produces the epitome of adverse selection and control fraud is the ultimate form of fraud.The examples Akerlof provided of sales of goods that posed lemon problems were anti-customer control frauds.

The CEA does not mention Akerlof in its discussion of lemon markets.This was deeply unfortunate, for it reinforced the CEA’s failure to discuss the epidemic of control fraud by nonprime lenders.The CEA also failed to explain one of Akerlof’s most important theoretical contributions in his 1970 article, the “Gresham’s” dynamic.Akerlof used Gresham’s law (bad money drives good money out of circulation in hyperinflation) as a metaphor to explain why market forces became perverse in the presence of asymmetrical information.The anti-customer control fraud that sells an inferior good through the claim that it is a high quality good gains a large cost advantage over its honest competitors.If they are driven into bankruptcy or emulate the fraudulent practices good quality goods – and honest sellers – will be driven from the marketplaces by competition.This happened recently in the Chinese infant formula market, where honest manufacturers were driven out of the market, six infants were killed, and over 300,000 were hospitalized.The perverse effects of extreme executive compensation largely driven by short-term reported earnings have now created a perverse Gresham’s dynamic in many firms, particularly in the finance industry.The CEA did not mention the perverse incentives produced by control fraud and modern executive compensation and why markets make the environment even more criminogenic rather than restraining fraud.Implicitly, however, the CEA recognized that there was some perverse market dynamic that could drive lemon markets to their nadir where “only the worst-quality” good would be sold.

The CEA compounded its error of not discussing Akerlof’s 1970 analysis of control fraud and the Gresham’s dynamic by failing to address George Akerlof and Paul Romer’s 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”).Their 1993 article analyzed accounting control frauds.The CEA’s discussion of financial intermediaries also included a discussion of “moral hazard.”As with its discussion of adverse selection, the CEA’s discussion of moral hazard implicitly excluded all fraud.There is no theoretical basis for this exclusion.Economics (and reality) has long recognized that moral hazard can lead to excessive risk or fraud.Fraud is often a superior strategy (in terms of expected value – not morality).As Akerlof & Romer stressed, accounting control fraud is a “sure thing” (1993: 5).“Gambling for resurrection” is a near sure thing, but in the opposite direction.The economic theory of how the insolvent or failing bank’s owners maximize the value of their “option” predicts that they will engage in such extraordinary risk that their gamble will nearly always fail.

But Akerlof & Romer endorsed another point that S&L regulators and criminologists stressed – the manner in which S&Ls purportedly engaged in honest gambling due to moral hazard made no sense for a rational (honest) actor.Please read their explanation with particular care for its obvious application to our ongoing crisis should be glaring.

“The problem with [economists’ conventional description of moral hazard as an] explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending:maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.*Examinations of the operation of many such thrifts show that the owners acted as if future losses were somebody else’s problem.They were right (1993: 4).”

Akerlof & Romer went on to explain that accounting control frauds optimize fictional income by making loans with a negative expected value and by deliberately seeking out borrowers with poor reputations (1993: 17).Their logic relies implicitly on the deliberate creation of adverse selection by the lender and the creation of a Gresham’s dynamic both among borrowers and those that aid and abet the CEO’s frauds, e.g., the appraisers when they inflate appraisals.

There is no good explanation for why the CEA would cite the Akerlof’s famous theory on lemon markets yet ignore the FBI’s 2004 warning, the experience of the S&L debacle (and the public administration literature on the successful regulatory fight against the control frauds), the Enron era accounting control frauds, Akerlof & Romer’s theory of accounting control fraud, and criminology’s theory of control fraud.The basic fraud mechanisms had so many parallels that one is forced to the conclusion that the CEA and its staff never read the most important modern economic article on bank failures.Akerlof & Romer explicitly noted that accounting fraud created perverse “lemon” projects (1993: 29).It is bizarre that the CEA wrote in 2006 for the express purpose of opposing essential financial regulation and thought that the best way to make its case was to cite theories most closely associated with George Akerlof while ignoring his application of those theories to financial regulation and his research findings on the reality of accounting control fraud.Note that Akerlof & Romer were writing about precisely the point the CEA was discussing – the role of banks with respect to information asymmetries.Worse, Akerlof & Romer’s point was that one could not assume that banks acted to reduce information asymmetries because banks engaged in accounting control fraud did the opposite.Akerlof & Romer also explained how accounting control frauds caused Texas real estate bubbles to hyper-inflate.If there was one economics article the CEA needed to read carefully it was Akerlof & Romer.Akerlof was a Nobel Prize winner well before the CEA wrote its 2006 annual report.

But the CEA could have learned the same vital facts about fraud and financial crises had it read the criminology literature, the regulatory literature on the S&L debacle, or the public administration literature.The CEA had experienced recently the Enron-era accounting control frauds and the S&L debacle was relatively recent.The CEA’s failure to even consider the role of fraud in financial crises, particularly after the FBI’s stark warning in 2004, was unconscionable.Akerlof & Romer went out of their way to warn economists of the dangers of control fraud.

“Neither the public nor economists foresaw that the [S&L] regulations of the 1980s were bound to produce looting.Nor, unaware of the concept, could they have known how serious it would be.Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.If we learn from experience, history need not repeat itself (1993: 60).”

My criminology colleagues and I sent the same warnings, as did the S&L regulators and public administration scholars.The FBI sent an explicit warning.None of us were able to get through to the Clinton, Bush, or Obama administrations.They have all ignored the epidemic of accounting control fraud that hyper-inflated the real estate bubbles and drove the financial crisis.

The Necessity and Centrality of Effective Underwriting

The CEA report continues its triumphal “just so” story approach to financial services by explaining how banks develop expertise in evaluating credit risk and use collateral as a means of inducing borrowers to “truthfully” rather than “strategically” release information on the true value of the real estate to the lender.By 2006, the nonprime industry was notorious for deliberately inflating appraisal values so that it could make more and larger fraudulent loans.Surveys of appraisers showed widespread efforts by lenders and their agents to coerce appraisers to inflate valuations.No honest lender would ever coerce an appraiser to inflate a collateral valuation.Only lenders and their agents can engage in widespread appraisal fraud.Appraisal fraud is a “marker” of accounting control fraud.The “strategic” behavior with regard to appraisers was by fraudulent lenders and their agents.It relied on endemic, deliberate deceit.Appraisal fraud is particularly egregious in residential home lending because it can lead borrowers to overpay for their home and to fail to understand the risks of purchasing a home.

The greatest analytical defect in this section of the CEA report, however, is its false dichotomy between economic efficiency and financial regulation.The CEA was on to something important.A well run banking system does reduce adverse selection and make markets less inefficient.A well run banking system does so by engaging in expert underwriting of significant loans such as home loans.A bank that does not engage in expert underwriting poses a grave danger.At best, it is incompetent.Far more dangerously, it is often engaged in accounting control fraud.A regulation that requires a lender to engage in prudent underwriting imposes no costs on honest banks and it saves society from vast amounts of damage.When the regulatory agencies gutted the underwriting rules by turning them into guidelines they set us on the road to the Great Recession.Effective financial regulation begins with mandating prudent underwriting.Rules mandating prudent underwriting make financial markets far more efficient and stable by blocking the perverse Gresham’s dynamic that otherwise can create a criminogenic environment.

The CEA was correct in explaining that the raison d’être of financial intermediaries is the provision of exemplary underwriting.It is, of course, significantly insane that the CEA would implicitly assume in 2006, contrary to known facts, that nonprime lenders, the investment banks packaging CDOs, and the rating agencies were prospering because they were engaged in exemplary underwriting.The CEA, in the two most important reports it issued in modern times (2005 and 2006), got the developing financial crisis and regulatory policy as wrong as it is possible to get something wrong.

Conclusion

No economist should be allowed to graduate from a doctoral program without reading Akerlof & Romer.It would also be salutary to expose any doctoral candidate interested in finance or regulation to the relevant work of criminologists and public administration scholars.Collectively, our work on control fraud has shown great predictive strength while neoclassical economic work (both macro and micro) and “modern finance” have suffered repeated, abject predictive failures.

Every financial regulatory agency should have a “chief criminologist.”The financial regulatory agencies are civil law enforcement entities whose primary responsibility is to limit control fraud, but they virtually never have anyone in authority with expertise in identifying, investigating, and sanctioning control frauds.

It’s actually a bit over the top and unfair to compare Barack Obama with Herbert Hoover – unfair that is, to the memory of Herbert Hoover. The received image of the latter is the dour, technocrat who looked on with indifference while the country went to pieces. This is actually an exaggeration. As Kevin Baker convincingly argued in his Harper’s Magazine piece, “Barack Hoover Obama”, President Hoover did try to organize national, voluntary efforts to hire the unemployed, provide charity, and sought to create a private banking pool. When these efforts collapsed or fell short, he started a dozen Home Loan Discount Banks to help individuals refinance their mortgages and save their homes. Indeed, the Reconstruction Finance Corporation, which became famous for its exploits under FDR and Jesse Jones, was actually created by Hoover. Often tarred with the liquidationist philosophy of his Treasury Secretary, the establishment of the RFC was, as Baker suggested, “a direct rebuttal to Andrew Mellon’s prescription of creative destruction. Rather than liquidating banks, railroads, and agricultural cooperatives, the RFC would lend them money to stay afloat.”

Hoover’s tragedy lay in the fact that whilst he recognized the deficiencies of the prevailing neo-classical laissez-faire nostrums of his day, he could not ultimately break with them and accept that the economic tenets which he had grown up with were deficient in terms of dealing with the huge unemployment challenges posed by the Great Depression. By contrast, Roosevelt was himself instinctively a fiscal conservative throughout much of the early stages of his political career (and campaigned as a gold standard man during the election of 1932), but ultimately had the vision (or, at least, excellent political instincts) to recognize the need to cut himself off from the dogma of the past and try something new in a persistent spirit of experimentation. Not everything FDR did worked, but his lack of rigid ideology and his bold spirit of economic experimentation ultimately did much to reduce the scourge of unemployment, even though such policies brought him into significant conflict with the economic royalists of his day.

Barack Obama’s style of governing largely reflects an acceptance of the status quo. His “economic experts” also reflects this preference. As Baker argued, “it’s as if, after winning election in 1932, FDR had brought Andrew Mellon back to the Treasury.”

To the extent that he displays any kind of radicalism, it is to roll back the frontiers of the New Deal and Great Society, in effect gutting the Democratic Party of its core social legacy. This assertion will no doubt inflame the diminishing Obama supporters, who insist the president would never cut Social Security or Medicare, that he’s merely been exploring every possible route to a deal with the GOP. But the evidence increasingly suggests otherwise.

Perhaps, as Salon.com’s Joan Walsh suggests, the president sincerely believes that the intense polarization of American politics isn’t merely a symptom of our problems but a problem in itself – “and thus compromise is not just a means to an end but an end in itself, to try to create a safe harbor for people to reach some new common ground”. One finds further support for this view within Barack Obama’s own writings. A major theme of his 2006 book The Audacity of Hope is impatience with “the smallness of our politics” and its “partisanship and acrimony.” He expresses frustration at how “the tumult of the sixties and the subsequent backlash continues to drive our political discourse.”

There appears little question, then, that the President values compromise, indeed appears to enshrine it as the apex of all great Presidencies (ironically citing Lincoln’s compromise on slavery as a perfect illustration of this ideal). But the problem with Walsh’s supposition is that the President’s accommodation with his political enemies, his apparent infatuation with a “third way”, suggests that he is being forced to compromise on a particular set of ideals and principles which he has hitherto embraced dearly.

But what is this President’s ideal? The only time in our national discussions where Mr. Obama has evinced any kind of passion has been during the debt ceiling negotiations. He has, since the inception of his presidency, elevated budget deficit reductions and the “reform” of entitlements as major transformational goals of his Presidency (rather than seeing deficit reduction as a by-product of economic growth). As early as January 2009, before his inauguration (but after the election, of course), then President-elect Obama pledged to shape a new Social Security and Medicare “bargain” with the American people, saying that the nation’s long-term economic recovery could not be attained unless the government finally got control over its most costly entitlement programs (http://www.washingtonpost.com/wp-dyn/content/article/2009/01/15/AR2009011504114.html)

In other words, Obama has been on about this since the inception of his Presidency. Recall that it was Barack Obama, NOT the GOP, who first raised the issue of cutting entitlements via the Simpson-Bowles Commission. The President has also parroted the line of most Wall Street economists as he has persistently characterized our budget deficits and government spending as “fiscally unsustainable” without ever seeking to define what that meant. One of his earliest pledges was to cut the deficit in half by the end of his first term, in effect paying no heed to the economic context when he made that ridiculous assertion.

In essence, the debt ceiling dispute is not forcing a compromise on this President, but is instead is viewed by him as a golden opportunity to do what he’s always wanted to do. That also explains why he won’t ask for a clean vote on the debt ceiling, why he has ignored the coin seignorage option, and why he has persistently avoided the gambit of challenging its constitutionality via the 14th amendment, even though his Democrat predecessor has already suggested that this is precisely what he would do: Bill Clinton asserted last week that he would use the constitutional option to raise the debt ceiling and dare Congress to stop him (http://www.nationalmemo.com/article/exclusive-former-president-bill-clinton-says-he-would-use-constitutional-option-raise-debt).

It also explains why President Obama remains infatuated by bigger and bigger “grand bargains”, which seem to take us further away from averting the immediate economic catastrophe potentially at hand, which is to say national default. The Administration, then, is not going for a bipartisan compromise, but going for broke on something which the President apparent holds sacrosanct. In reality, true compromise would start with the notion of a clean vote on the debt ceiling or, at the very least, a minimal series of spending cuts that would avert the immediate risk of a default, whilst creating less deflationary pressures.

Have you actually seen the President ever get angrier than he was at his press conference announcing the collapse of the negotiations on the debt ceiling extension? Not even on health care “reform” can we ever recall seeing Obama this engaged, and manifesting something close to real emotion as he has here. That does suggest something beyond mere political calculation; it hints at core beliefs.

And to what end? Neither he, nor the Congress appear to recognize the downward acceleration in GDP triggered when the spending limits are reached if the automatic stabilizers are disabled because they are no longer funded as a consequence of the debt ceiling limitations (again, a LEGAL, rather than operational constraint – the debt ceiling reflects an UNWILLINGNESS to pay, rather than an INABILITY to pay).

So spending will be further cut, debt deflation dynamics will intensify, sales will go down more, more jobs will be lost, and tax revenues will collapse even further. Which will set the whole process off again: more spending is cut, sales go down more, more jobs are lost, and tax revenues fall more, etc. etc. etc. until no one is left working. All are radically underestimating the speed and extent of the subsequent damage.

Unlike President Hoover, who inherited the foundations of a huge credit bubble from the 1920s and found himself overwhelmed by it, this President is worse. He is, through his actions, creating the conditions for a second Great Depression because of his misconceived belief that too much government spending “crowds out” private investment, and takes dollars out of the economy when it borrows.And therefore, goes the perverse logic, when the government stops borrowing to spend, the economy will have those dollars to replace the lost federal spending.

And so after the initial fall, Obama believes, it will all come back that much stronger.

Except, that as my friend Warren Mosler insists, he is dead wrong, and therefore we are all dead ducks.

As Warren notes, have you ever heard anybody say ‘I wish they’d pay off those Tsy bonds so I could get my money back and go buy something.’?

Of course not! Notes Warren:

“Treasury borrowing gives dollars people have already decided to save a place to go. Dollars that came from deficit spending- dollars spent but not taxed. If they were spent and taxed, they’d be gone, not saved.

Treasury bonds provide a resting place for voluntary savings. They are bought voluntarily. They don’t ‘take’ anything away from anyone.

For example, imaging two people, each with $1 million. One pays a $1 million tax. The other doesn’t get taxed and decides to buy $1 million in Treasury bonds. Pretty obvious who’s better off, and who’s still solvent and consuming.”

Someone please explain this basic economic tenet to the President so that he can effect a genuine compromise, not a destructive “grand bargain” which will suck trillions of demand out of a still fragile economy. The predictable result is of his current stance is that, even as he claims to recognize the interlocking nature of the problems facing us and vows to “solve the problem” once and for all via a “grand bargain”, Obama is in fact tearing apart most of the foundations which were tentatively initiated under Hoover, but which came to full fruition under FDR. If he continues down this ruinous path, $150 billion/month in spending will be cut. Such economic thinking isn’t worthy of Mellon, let alone Herbert Hoover.

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Last week we raised the following question: Where currency cannot be exchanged for precious metal, and if legal tender laws are neither necessary nor sufficient to ensure acceptance of a currency, and if the government’s “promise to pay” really amounts to nothing more than exchanging one 5 Dollar note for another 5 Dollar note, then why would anyone accept a government’s currency? This week we explore the MMT answer.

Taxes drive money. One of the most important powers claimed by sovereign government is the authority to levy and collect taxes (and other payments made to government including fees and fines). Tax obligations are levied in the national money of account—dollars in the US, Canada, and Australia, Yen in Japan, Yuan in China, and Pesos in Mexico. Further, the sovereign government also determines what can be delivered to satisfy the tax obligation. In all modern nations, it is the government’s own currency that is accepted in payment of taxes.

We will examine in more detail in coming blogs exactly how payments are made to government. While it appears that taxpayers mostly use checks drawn on private banks to make tax payments, actually, when government receives these checks it debits the reserves of the private banks. Effectively, private banks intermediate between taxpayers and government, making payment in currency (technically, reserves that are the IOU of the nation’s central bank) on behalf of the taxpayers. Once the banks have made these payments, the taxpayer has fulfilled her obligation, so the tax liability is eliminated.

We are now able to answer the question posed earlier: why would anyone accept government’s “fiat” currency? Because the government’s currency is the main (and usually the only) thing accepted by government in payment of taxes. To avoid the penalties imposed for non-payment of taxes (that could include prison), the taxpayer needs to get hold of the government’s currency.

It is true, of course, that government currency can be used for other purposes: coins can be used to make purchases from vending machines; private debts can be settled by offering government paper currency; and government money can be hoarded in piggy banks for future spending. However, these other uses of currency are all subsidiary, deriving from government’s willingness to accept its currency in tax payments.

It is because anyone with tax obligations can use currency to eliminate these liabilities that government currency is in demand, and thus can be used in purchases or in payment of private obligations. The government cannot readily force others to use its currency in private payments, or to hoard it in piggybanks, but government can force use of currency to meet the tax obligations that it imposes.

For this reason, neither reserves of precious metals (or foreign currencies) nor legal tender laws are necessary to ensure acceptance of the government’s currency. All that is required is imposition of a tax liability to be paid in the government’s currency.

What does government promise?What does a government IOU owe you? The “promise to pay” that is engraved on UK Pound notes is superfluous and really quite misleading. The notes should actually read “I promise to accept this note in payment of taxes.” We know that the UK treasury will not really pay anything (other than another note) when the five Pound paper currency is presented. However, it will and must accept the note in payment of taxes. If it refuses to accept its own IOUs in payment, it is defaulting on that IOU. What was it that President Bush said?

“There’s an old saying in Tennessee — I know it’s in Texas, probably in Tennessee — that says, fool me once, shame on — shame on you. Fool me — you can’t get fooled again.”

Forgive him as he probably listened to Roger Daltry a bit too much back in his partying days. What he meant is that the sovereign can fool me once—shame on government—but it cannot fool me again. (That, folks, is what led to the creation of the Bank of England! A story for another day.)

This is really how government currency is redeemed—not for gold, but in payments made to the government. We will go through the accounting of tax payments later. It is sufficient for our purposes now to understand that the tax obligations to government are met by presenting the government’s own IOUs to the tax collector.

Conclusion. We can conclude that taxes drive money. The government first creates a money of account (the Dollar, the Tenge), and then imposes tax obligations in that national money of account. In all modern nations, this is sufficient to ensure that many (indeed, most) debts, assets, and prices, will also be denominated in the national money of account.

(Note the asymmetry that is open to a sovereign: it imposes a liability on you so that you will accept its IOU. It is a nice trick—and you can do it too, if you are king of your own little castle.)

The government is then able to issue a currency that is also denominated in the same money of account, so long as it accepts that currency in tax payment. It is not necessary to “back” the currency with precious metal, nor is it necessary to enforce legal tender laws that require acceptance of the national currency. For example, rather than engraving the statement “This note is legal tender for all debts, public and private”, all the sovereign government needs to do is to promise “This note will be accepted in tax payment” in order to ensure general acceptability domestically and even abroad.

Ok we need a cliff-hanger. Here are two questions to ponder for Wednesday:

Does this work only for taxes? Could other obligatory payments work? Like what?

What if you do not, personally, owe taxes? Why would you accept the government’s currency?